A small business loan can sometimes come with a long list of requirements, and one thing a lender may expect you to have is collateral. Generally, collateral refers to some type of asset owned by the business. Not all types of business financing requires collateral, however. Learn why lenders sometimes require collateral and how to get a business loan without collateral.
[Read: Best Unsecured Business Loans.]
Why Lenders Ask for Collateral for Small Business Loans
Lending money involves a certain amount of risk, particularly when the borrower is a small business. If the business isn't as profitable as it expects to be or something happens that reduces cash flow, repaying a loan could be more difficult or even impossible. When a business loan goes unpaid, the lender ends up with a bad debt on its balance sheet.
A lender can try to collect on a bad business debt in different ways, including by suing the business owner. Attaching collateral to the loan can offer a shortcut, allowing the lender to liquidate assets to recoup the debt. The types of assets that may be used as collateral for a business loan can include:
-- Business equipment
-- Business inventory
-- Real estate the business owns
-- Cash held in a business checking or savings account
-- Personal assets you own outside of the business, such as your home
The amount of collateral required can vary based on the amount of the loan and the lender's policies. But the purpose of requesting collateral for a loan is the same. If a borrower doesn't make good on his or her loan payments and ends up defaulting, the lender can take ownership of the collateral in lieu of payment for the balance. The collateral could then be sold to satisfy the debt.
Even though a lender may not ask you to pledge a piece of equipment or a building you own as collateral, it may use other means to minimize its risk. A personal guarantee is one option; a blanket Uniform Commercial Code lien is another.
With a personal guarantee, you as an individual enter into a legal agreement with the lender regarding liability for the debt. Essentially, a personal guarantee makes you personally responsible for repaying the loan, even if you take it out for your business.
That means if you default, the lender could pursue debt collection actions against you, including suing you in civil court. If a lender were to win a judgment against you, it could then try to get some financial relief for the debt by garnishing your wages, your bank account or other assets, depending on the debt collection laws in your state.
A blanket UCC lien doesn't pinpoint specific assets the business owns as collateral for a loan. Instead, it gives the lender the right to legally pursue any business assets if you default. Like collateral, a personal guarantee or a blanket UCC lien is something that's designed to protect the lender from financial loss.
Small Business Financing Options Available Without Collateral
The key to getting a small business loan without collateral is knowing what options are available. You might be able to qualify for some of these business financing options without collateral, though offering collateral might improve your changes of approval or your terms. And without collateral, you may be required to provide a personal guarantee or UCC lien.
Small business funding options that may offer approval without collateral include:
-- SBA 7(a) loans
-- Term loans
-- Merchant cash advances
-- Business lines of credit
-- Business credit cards
Here's how they compare:
SBA 7(a) loans. If you need larger amounts of funding at competitive interest rates, the Small Business Administration's loan program may be an option. The SBA doesn't extend loans directly; instead, it partners with lenders to secure loans offered to small businesses.
The 7(a) loan program allows qualified businesses to borrow up to $5 million. Collateral isn't required for 7(a) loans up to $25,000. For loans of more than $350,000, the SBA requires lenders to try to secure the loan as much as possible, based on the assets that borrowers have available. If your business doesn't have sufficient assets to offer as collateral, the SBA and its partner lenders may take other factors into account for loan approval. However, approval requirements may vary based on the lender.
Keep in mind that an SBA loan may be more challenging to qualify for than a conventional business loan, and lenders require extensive documentation. "Business owners typically need a solid credit score and should be prepared to supply income tax returns, financial and bank statements, and various legal documents," says Andrea Roebker, regional communications director for the U.S. Small Business Administration Great Lakes region.
Additionally, businesses must meet the universal requirements for an SBA loan. For example, the business must operate as a for-profit enterprise, qualify under the SBA's definition of a small business and be based in the U.S.
Just be aware that while you may not need collateral for a 7(a) loan, the SBA may still expect you to offer a down payment. The minimum down payment for these loans is 10% of the loan amount, but the lender may ask for a higher percentage, depending on how much you're borrowing and what the loan will be used for.
You'll also need to offer a personal guarantee for an SBA loan if you own 20% or more of the business, so be prepared to put some skin in the game.
Term loans. A term loan is any loan that offers a lump sum of funding that's repaid over a set time period. For example, a mortgage is a type of personal term loan.
Business term loans can be either short-term or long-term. Short-term business loans are typically more suited to covering immediate funding needs, such as paying quarterly taxes or meeting payroll for the month. Long-term business loans are more appropriate when you need to borrow a larger amount for a growth investment, such as to open a new location. Long-term loans can also be useful for refinancing or consolidating existing business debt.
You can find term loans through banks, credit unions or online lenders, some with no collateral requirement. Which one you choose can depend largely on the lender's minimum requirements. For instance, you may have an easier time going through an online lender if you're looking for a startup business loan that doesn't require collateral. Online lenders may also be less restrictive when it comes to lending to those with poor credit.
Merchant cash advances. A merchant cash advance is not a loan, per se. When you take a merchant cash advance, the finance company is advancing you money against your future credit card receipts. You then pay that money back to the lender, typically through daily or weekly payments, with interest. The payment is deducted automatically from your credit card receipts and sent to the provider of the advance.
There's no collateral required and no down payment for a merchant cash advance. This type of financing may be easier to get for newer businesses that don't have a lengthy credit history, as it's based on your credit card sales.
Business line of credit. It's also possible to get an unsecured business line of credit. Banks, credit cards and online lenders can offer lines of credit. They work similarly to a credit card, in that you have a revolving line you can draw against as needed. You only pay interest on the amount of your credit line that you use.
The only hitch is that a business line of credit may be more difficult to qualify for compared with a merchant cash advance or a term loan from an online lender, especially if you're not offering collateral. You may need to have operated for a certain number of years, reach a minimum credit score and earn a certain amount of annual revenue to get a business line of credit with no collateral.
Business credit cards. Business credit cards offer flexibility with spending, as well as the potential to earn cash back, points or miles on business purchases. An unsecured credit card requires no collateral, although you may have to agree to a personal guarantee for approval.
The advantage of business credit cards is that they're relatively easy to qualify for if you have good personal credit. It's even possible to get approved for a business credit card before your business launches.
Pay attention to the annual percentage rate and fees associated with any business card you're applying for, particularly if you think you may carry a balance. High interest can make every business purchase more expensive if you don't pay in full each month.
Also, weigh the merits of getting a business charge card instead. Charge cards can still offer rewards, but they don't charge interest since they're paid in full monthly.
[Read: Best Small Business Loans.]
Look at the Big Picture When Getting a Small Business Loan
"It's important to remember that collateral does not guarantee an approval or denial," says Victoria Hassett, manager of the Emerging Enterprise Program at the University of Pittsburgh Institute for Entrepreneurial Excellence. "A variety of other things could impact the approval or denial, such as personal credit history, the historic financials of the business, the industry and experience of the owner."
Take time to ensure that you're presenting the strongest financial picture possible before applying for a small business loan. Resolving negative credit items, such as defaulted personal debts, and establishing a positive banking history can help your business put the best foot forward when approaching a lender for an unsecured loan.
"Find a banker you trust, who guides you through the lending process while providing financial advice," Hassett says. "It could save the business in the long run."